10 Questions to Mohnish Pabrai – The Answers

July 13, 2007

GuruFocus readers are given an opportunity by Mr. Mohnish Pabrai (also a GuruFocus reader) to ask 10 questions. We got answers back from Mr. Pabrai to some questions.

There were overwhelming responses and we have received more than 100 questions. We are very proud of the quality of the questions that our readers asked. We sent 17 questions to Mr. Pabrai. These are his answers to some of them.

How does your investment philosophy differ from Warren Buffett’s and Charlie Munger’s and why? As a follower of Warren Buffett you insist in buying into companies with a "moat"; nevertheless the kind of companies you tend to invest in do not appear to have wide moats as generally described by Warren Buffett and reflected in his holdings like Coca Cola, Gillette or American Express. Could you please expand on your definition of a moat and contrast it with Warren's definition? Warren Buffett stated that his ideal holding period is 'forever,' and that 20 investments in a lifetime are more than enough for any individual investor. Do you agree with these statements, or should one be more flexible in their investing strategy?

There are many different approaches that Buffett has applied over his long career. Even today, Buffett’s investing approach when investing for his own account differs significantly from his approach when allocating capital for Berkshire . Berkshire is a very inefficient vehicle for investing in stocks. Gains are taxed at 35%. In addition, shareholders are taxed when they sell Berkshire stock. Plus Berkshire is drowning in cash. With these realities, the best approach for Berkshire is to buy and hold stocks for a long long time.

If you’re a buy and hold forever investor, then having a very durable moat becomes extremely critical. Berkshire needs to invest in businesses that have very high returns on equity (Coke, Moody’s American Express), the ability to redeploy earnings at high rates of return and it needs to buy into these businesses below intrinsic value so that the annualized return is atleast the returns the businesses generate on their equity. Very very few businesses generate ROE exceeding 15-20% annually and have the ability to redeploy earnings at greater than 15-20% ROE. Thus it is unlikely Berkshire ’s stock portfolio can generate long term returns exceeding 15%. Their float helps then get higher effective returns. Buffett once said that float added about 7% to Berkshire annualized returns.

On the other hand, Buffett the individual investor can buy a cheap stock and sell it at full price and pay mostly 15% long term gains. He gets taxed once. It is very efficient. Thus Buffett bought REITs when they got cheap – and then sold them all. He bought Korean stocks when they got really cheap. He’s either already unloaded or will unload those stocks in a year or two. He generates much higher returns for his own portfolio than Berkshire does. It is much smaller and does not have the incentives Berkshire has to just do buy and hold forever investing.

So, if you bought a business worth a dollar for fifty cents and it was a below-average business with a shallow moat. Let’s assume you held the business for 2 years and during those two years intrinsic value grew by zero, but the market recognized it was worth a dollar and two years later it was trading at a dollar. Now, if you sold it after 2 years, you annualized returns is over 41%. Buy and hold forever cannot generate 40+% annualized. If you have small amounts of capital and are focused and patient, you’ll probably get a chance to take that dollar and invest it in another 50% off business and convert it into two dollars in a year or two.

Plan A is always to buy the Coke and Moody’s of the world at 50% off. If you buy these type of businesses at that discount and it takes 2-3 years to trade at intrinsic value, you’ll do very well. Intrinsic value will be much higher in 2 to 3 years. So 50 cents may be worth $1.30 or $1.40. This is always Plan A. But plan A is virtually impossible to execute across the entire portfolio because they are so very very rare.

When plan A fails, we go to plan B. Plan B is to buy at half off, regardless of business quality (as long as you’re pretty sure intrinsic value is very unlikely to decline). Most of Pabrai Funds investments over the years have been Plan B.

Could you briefly provide some valuation techniques you use? Which method you favor or something else? I have read that if you find you are looking for excel while valuing, you take a pass. What’s your thought process when you value a company? Do you use models like a) Reproduction Costs of assets Earnings PV/Enterprise Value? b) DCF?

Depends on the situation. In some cases you can only hang your hat on liquidation value. In other cases there is enough of a moat to focus on future cash flows. There is no need for Excel. If a business has zero growth and consistent stable cash flow, that business is worth 10x FCF plus any excess capital. I then divide by two and see if it’s available at half off. If there is growth, depending on how much and how consistent, I’d be willing to value it at 12-15x plus excess capital.

It should be obvious if something is a bargain or not within a few minutes without Excel.

I would ask Mr. Pabrai to expand on the distinction he made in his book "The Dhando Investor" between "risk" and "uncertainty". He wrote about investing in "low-risk, high-uncertainty" situations. What are some guidelines for distinguishing whether it's risk or merely uncertainty that has depressed a stock's price?

Chapter 13 of The Dhandho Investor lays out this concept quite well. At 23 pages, it’s one of the largest chapters in the book. The best way I can answer this is with an example. And the best example the comes to mind is Frontline. The Frontline case study is laid out in Chapter 13 as well. That was a situation where the business was trading at ¼ of liquidation value due to severe distress in the entire oil shipping industry. Unlike a steel mill or amusement park, here was a business whose primary assets were crude carrying ships. These ships were regularly bought and sold nearly every week and it would be relatively easy to liquidate the business – one or more ships at a time.

Balance sheet was very solid. Frontline was losing money but had plenty of liquidity and could raise nearly unlimited liquidity to cover any cash crunch by selling one or more ships.

So, there was virtually no downside – virtually non-existent risk. And there were forces at work to make the company tremendously profitable in the not-so-distant future. The uncertainty was when they’d return to profitability. There were about 400 VLCCs globally at the time. Oil demand, on average grows 2-3% a year. So there is a need for 8-12 additional ships a year. Plus when rates are so low, old ships get scrapped. So the 400 ship global fleet might be at 390 or 395 in a few months due to scrapping. Then when oil demand starts coming back, there aren’t enough ships (takes years to order and build one).

Frontline was a classic ultra low-risk bet with ultra high uncertainty. The stock went from $15 to $3 when the industry got distressed. Liquidation value was $12-14/share. Eventually the stock went over $60 – and that’s after substantial dividends and a spinoff. We were out in the low teens, but still did quite well.

If you understand the business, it becomes easy to see if risk is low or high and if uncertainty is low or high. It’s all about staying squarely within circle of competence.

What do you do with an investment which has performed unexpectedly or poorly? What information do you find most useful in this situation in deciding to sit tight, to sell or to buy more? When do you decide its time to throw in the towel before losing more of your original investment? For me, finding good companies to buy is usually not that hard; it's knowing what to do with them after you own them that's the hard part. Thanks for your advice - you are my favorite guru!

Thanks for the complement! I suggest reading Chapter 15 in the book. It’s called Abhimanyu’s Dilemma and it’s all about how to deal with poorly performing investments. The key points are that you need to know what a business is worth and not let the market tell you that. Second is to be patient to give Mr. Market time to agree with you.

What has been your biggest investment mistake? Not just a stock that did not perform as expected but a process or method error? (Loved Dhandho Investor!)

Sometimes the big mistakes aren’t ones you lose money in. Before I started Pabrai Funds, I had 2 investments that did spectacularly well. In 1995, I bought stock in Satyam Computer Services in India for about Rs. 40 per share on the Bombay Stock Exchange. By 2000, it traded at Rs. 7000 per share. Over that time the rupee got weaker and I suffered about a 30% loss due to devaluation, but it was still over 100x in 5 years. At that time, my (flawed) investing framework dictated that I should never sell great businesses. Satyam was a tremendous business run by an exceptional CEO (Rama Raju). Finally, in 2000, I woke up and realized that it was trading at very ridiculous multiples. When I bought it, liquidation value was over Rs. 40. Plus they were earning nearly Rs. 7 per share. And those earnings were easily going to grow at over 50-100% a year for atleast a few years. I was lucky. I sold within 10% of the top. Satyam subsequently bottomed out at about Rs. 1000. I haven’t tracked its valuations in recent years, but I don’t believe it’s even today reached its Rs. 7000 price yet – even though they are much larger. Still remains a great business run by wonderful people. The mistakes with Satyam were two-fold. One, I invested under $10,000 in it, when I should have put atleast 10x that number into it as I had about $1 Million in investable assets. Second, I should have sold well before Rs. 7000 – when it reached intrinsic value.

Buffett invested in three distinct categories- Generals, Workouts, and Controls. I know you tend to avoid the latter, but relating to Generals and Workouts- how do you feel those types of investments apply to today's market? Grahamian Bargains, which can see huge returns with small amounts of capital, seem to be scarce, and M&A is so heavily covered that "workouts" now may be different than in Buffett's era. Do you have any particular comments on investing in "Generals" and "Workouts" as they apply to investing today?

I think in terms of two kinds of investments – placeholders and normal. Placeholders, like Berkshire Hathaway, are stocks with ultra-low downside and decent upside, but not at a 50% discount to intrinsic value. I’ll part money in these till a real/normal investment opportunity shows up. The normal investment opportunities are those that are available at 50% off of intrinsic value. These can be distressed, misunderstood etc. type businesses. Sometimes macro conditions can lead to very normal businesses trading at half off. That’s wonderful.

In pages 24-27 of "Mosaic: Perspectives On Investing", you come right out and say, "Do Not Buy Retailers". Some of today's retailers are priced very attractively today (eg. HD and WMT). The fundamentals of these companies look great and I see them as compelling reasons to buy. However, you didn't like retailers because of the transparency of the business. To me, it seems hard to duplicate a HD or WMT, but I could be wrong. It's been 5 years since your book was written and several retailer stocks have come down in price because of apathy among other things. Then, in "The Dhandho Investor", you evaluate BBBY (albeit not worth buying at the time), which implies you at least consider some retailers. My question is, "Do you still have the same conviction today to say, 'Do Not Buy Retailers' or has your opinion changed? Will you ever buy a retailer?"

Yes, some retailers are fantastic. I almost bought one recently, but it was just a tad over 50% off, so I passed. Costco is awesome. I’d love to own Costco. Just can’t bring myself to buy at current prices.

It’s all related to circle of competence. If you’re confident about future cash flows etc. then it’s worth delving into. I’ve never studied BBBY. Just did the basic quantitative analysis I wrote about in Dhandho.

(After reading "The Dhandho Investor" I have a few general questions) What suggestions (or more examples) can you give GuruFocus readers on the art of selling, which I consider a very difficult part of investing for a value investor.

Don’t have anything more to add to Chapter 15, Abhimanyu’s Dilemma on the subject.

Mr. Pabrai said he is working on other questions. It will take a while for us to get those back. We post what we have received here and will keep you updated on the rest ones.

To our honor, Mr. Pabrai said that GuruFocus has provided “a terrific service to the community.” He himself is “fan of your site.” Evidently Mr. Pabrai lists GuruFocus as one of his favorite sources for generating investment ideas in his new book, The Dhandho Investor. Also he is one of the earliest registered users of GuruFocus, his user ID is 48, which is out of more than 20,000 registered. If you have not registered, please register today.

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Comments

"The mistakes with Satyam were two-fold. One, I invested under $10,000 in it, when I should have put atleast 10x that number into it as I had about $1 Million in investable assets. Second, I should have sold well before Rs. 7000 – when it reached intrinsic value."

I read: You can make as much by taking a substantial stake in a low-risk situation as you can by taking many small stakes in high-risk situations.

Pabrai is my favorite guru as well!!!! He also "gives back", to his credit, not only to the average investor but he bgives to other charities as well! Not even Warren Buffett is not as generous with sharing his knowledge like Mr. Pabrai!!

Referring to Satyam, there is something inspirational when someone says they held to long when selling 10% from the top. It's nice to see honesty and not bragging.

As an aside:

The more I read, the more I realize I have lots to learn.

Retail aside 1:

In terms of retail, let’s take two extremes. Wal-Mart seems to be very efficient, especially with inventory controls. Then again, Home Depot has serious inventory problems. Their computers rarely know what is stocked where. So, Lowes is simply better here. But a third corporation could always come with a Wal-Mart like inventory system, creating lower prices to the customer and before you know it, the big two home improvement places are Lowes and ABC corp. HD will be in trouble. I think this is not going to happen since I don’t see any ABC Corp on the horizon, but the concept holds.

Retail aside 2:

Another comment on retail. My favorite is TJX. They are a conglomerate of retail stores. If one is weak, they can sell it off. The good models will just expand over time. Some stores like Marshalls and TJ Maxx even stock the same goods, so having two nearby don't cannibalize themselves.

Thank You Mr. Pabrai! It’s wonderful to see a guru help out those trying to learn more.

Mr pabrai is a class act .His secretary said he enjoyed an email I sent him and he had the class to have her personally respond.

FYI: If you are going to purchase a small cap "following" a guy like Pabrai is your best bet. To expect to have the expertise to do this on your own is not as easy as Mohnish makes it seem.lol This man is a wealth of wisdom and his tempermant is excellent. Buying at or near a stocks 52 week low is another of his methods as well as searching gurufocus

The main lesson I learned from Mr. Pabrai's book and answers to questions is to buy lower and sell lower. I've been mistakenly trying to emulate Buffett's current methodology of buying great businesses for a reasonable price and holding a long, long time. There's nothing wrong with that of course. But for an individual small-scale investor like myself, it does seem better to look for the 50 cent dollars-on-sale, take the short ride to 90 cent dollars and move on. I also have to be more patient (who of us doesn't!?) and learn that it is okay to sit on some cash and wait for the next 50 cent dollar.

This revelation has already had an influence on my activities. I bought Garmin when I figured it to be extremely undervalued a couple of years ago. It is quite analogous to Satyam Computer Services, great management, growing revenues, etc. It is also analogous in that it's price has now exceeded my fair value estimate. I didn't make the mistake of betting too little---I put 45% of my portfolio into it---but I was on the verge of making the mistake of holding too long. I'm now selling off. The business is doing fine, so I'm waiting for long term cap gains rates on shares and options that were bought less than a year ago.

BTW, thanks also to gurufocus for the RAIL tip. After due diligence I bought some 30 cent dollars there.

wise post buffeeteer17. Buffett holdson not only because of his large positions but because he knows that the"governmental deferred taxes loan" and the float is beneficial over time.Like someone else pointed out many "bargains" like Berkshire itself was a huge mistake. KO WFC JNJ AXP BUD PG have brand names which could not be "started from scratch".You did great on garmin buying it and are "exiting" at just the right time IMO.Small caps have outperformed large for last 8 years and while there are always bargains. large caps of consumer staples are the "safe haven". Glad to see you with JNJ.its great vallue now. peace

It was nice of Mr. Pabrai to respond to my question, though I'm not sure how helpful that particular example from his book will be for anyone trying to replicate what he does, since stocks selling for 1/4 of their book value are rare. But I think I understand better now how Pabrai differentiates between risk and uncertainty: he does a ton of homework on the particular situation to find out.

One recent example is HNR. I doubt I'm the only one who looked at this Pabrai holding when it was trading under $10 and thought: Chavez = raving socialist = HNR gets nationalized. To me, Chavez equaled risk, not just uncertainty, but Pabrai apparently did his homework on this one, and figured (correctly, so far) that Chavez wasn't stupid enough to scare off all the competent oil industry people; he just wanted to squeeze them for a bigger piece of the business.

Pabrai's advice to invest in "low-risk, high-uncertainty" businesses is sage, but homework and execution are everything. It's like Tiger Woods telling you to keep your left arm straight on your drives.

Mohnish says above that he almost bought one retailer, but then didn't because it was "tad over 50% off, so [he] passed". I thought his strategy was to buy 50% off, or a greater discount if possible. What was it that made him pass given the price met his major criterion. Was there something else about the investment he didn't like? (I guess we'd have to pose this question directly to Mohnish).

ravinsu: Sometimes companies are able to finance their growth out of cash flow without any borrowing. Examples, RAIL, CSCO, MSFT, EBAY, GRMN, etc. These companies all produce so much net cash, they have no debt and money left over after spending for expansion. Shouldn't the WACC for such companies be lower than for ones that borrow to finance growth? Take RAIL for example (being discussed in another thread), with a likely long term growth rate of 4-6%/year. They have $15/share in net cash and a substantial cash flow, so they don't need to borrow at all. To value the company, I use a WACC of 10% which is somewhat arbitrary...it is based on what I think I could make nearly risk free plus a small premium. Thus we have a multiplier of 1/(WACC-G) = 1/(0.1-0.05) = 20.

The Dhandho is still shipping to my home, so I have to wait to understand better the methodology. But seemingly one of the most important factors for Pabrai is to buy 50% off the intrinsic value.

According to that, do you think it would be a Pabrai's way just to collect the valuation of Morningstar and buy when the stock price is 50% off the fair value?. I know it sounds simple.. what guys do you think?.

yes ravinsu you are correct about that.My formula I use assumes a much lower percentage of return that I "expect" to get. the lower price you buy something to intrinsic value the higher your return"should be". My problem is unlike almost everyone else here including most of the gurus I have very"narrow" parameters. Great discussion guys

I like Pabrai and he certainly has an incredible track record. But I found his answer to the "biggest mistake" question frustrating, self-serving and, in the end, sort of lame. He has had some investments where he really blew the analysis (Seitel and Exide are good examples). Grossly overvaluing XIDE by using faulty plan projections (when the operating business was utterly predictable and simple to value even with lead volatility) would have been more interesting to read about than his "not buying enough" of a 100 bagger. He's a great investor and has proved he can outperform over a long time period. But I don't see why he had to cop out on us by not telling us about times when his valuation process has failed him.

Financially I think that was his biggest mistake. If he had put 10% into that position like he does now imagine the return he would have made. We are talking about a stock that went up 175 times, 100,000 * 175 is a lot of money. I'm guessing this really was his biggest mistake.

Wonderful article! There's something that I don't understand though and it would be nice if someone can answer my question. Mr. Pabrai mentioned in his answer to Question #2 that "it should be obvious if something is a bargain or not within a few minutes without Excel." However, for Q3 his analysis of Frontline shipper seems to require way more than a few minutes of time. (e.g. finding out that "There were about 400 VLCCs globally at the time") So, I am a little confused here... Pabrai iterates over and over in Dhandho that finding bargains could be quite simple and yet from his analyses it seems to me that the effort required could be quite time consuming.

The thing I don't understand about the Frontline example is that; could they have actually sold the ships had they needed to, and who would have bought them? Surely there is a risk that, since there was 'severe distress' in the oil shipping industry, nobody would have wanted them. Ultimately that wasn't tested by the looks of things because of a cyclical recovery. But the risk was there...

I believe the financial statement analysis is simple. I would venture to guess that pabrai spends the balk of his time understanding the business and mentally playing out the odds. I believe he is staying don't spend weeks with excel doing regression analysis with pivot tables and the like.

The definition of a cheap stock being 10-15 times FCF (plus any spare cash/ investments). And then he wants a 50% discount to this valuation - this is equivalent to a yield of 13.3-20% of FCF/ EV. Pretty hard to find stocks with this criteria. However I just did a screen and found 73 stocks that meet the criteria.

Hopefully there will be 1 good stock out the 73 that I can pick.

Has anyone read his book: Mosaic: Perspectives on Investing? It's over $300 per copy to buy it :)

There's a story about John von Neumann teaching a math class at MIT. He was filling the black board with formulae and at one point he wrote a complex equation while saying "...it is obvious that..." Then he frowned, paused, cupped his chin and silently paced back and forth for 30 minutes. Then he smiled, said "Yes! it is obvious" and went back to writing formulae.

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